My opinions on value investing. The idea is to create a value discussion on stocks and concepts. You might find this blog leaning a bit towards Dalal Street but the concepts should travel well across global markets.
Please note that I may or may not have a position in these stocks. Please use these opinions after through independent research and at your own risk.

The Basics

100 rupees in the bank today are worth 100 rupees to you today as you can go to an ATM withdraw it and spend it right away. What are 100 rupees expected 1 year from now?

This depends on 2 factors:

Probability of receiving the 100 rupees

Interest rate

The lower the probability of receiving the 100 rupees the higher the interest rate. The interest rate at 100% probability is called the risk free rate. There is nothing that is actually risk free but government bond yield over the same period is called the risk free rate.

The probability of earnings in a company is far from risk free. Your interest rate (or discount rate as it is called in the equities world) is the return you expect from the security. For a company that is highly likely to produce earnings (for example a utility provider whose demand is completely inelastic) the discount rate assumption is typically AAA rated corporate bond yield net of tax. For simplicity in this discussion we will assume this yield to be 9.8%, which means a post tax return of 6.86%. Typically stocks with low single digit growth and high probability of consistency should trade at around 1/6.86% = 14.5 times earnings. Reason for 1/bond yield is because this is priced like a perpetuity.

The earnings multiple

The earnings multiple or P/E is typically a good measure of value. Assuming that the growth from the 5th year till the 10th year will be 8% and a 20% expected return on equity the implication of a P/E multiple is shown below. So if a stock is trading at a

AAA
Coporate bond yiled

9.80%

Net of tax
yield

6.86%

5 to 10 year
growth rate

8.00%

Expected
Return from equity

20.00%

Dividend Yield

0.00%

P/E

5 year Growth
Required for a fair price

10

6%

12

11%

15

17%

16

18%

17

19%

18

21%

20

24%

22

26%

Another parallel analysis that I saw on Prof Bakshi's blog comments was to assume 15x multiple after 5 years and calculate the IRR assuming today's purchase price, dividends and the exit. Both styles of analysis give fairly similar results. For companies already trading below 15x earnings assuming an exit at 15x is a bit

Impact of Quality of company - the moat

The moat does 2 things:

Below a certian moat grade one should stay away. An example of this might be sponge iron manufacturers or oil miners or any miners where the protfitability purely depends on the commodity cycle. Those are dangerous as prices can move both ways and you are essentially buying commodity futures with higher than commodity futures risk. There can however be cigarette butt investment opportunities in the space.

The better the moat the lower the risk of earnings consistency and earnings growth. Higher probability of growth means that the growth This drives valuations of some companies to absurd levels where the investors are willing to take lower rates of rate. In reality taking a 6% discount rate and 22% growth rate you can even justify a 30x multiple. Such multiples are valid only in very rare cases.

P/E

6%

10%

15%

10

-2%

1%

6%

12

1%

5%

10%

15

6%

10%

15%

16

7%

11%

16%

17

9%

13%

18%

18

10%

14%

19%

20

12%

17%

22%

22

14%

19%

24%

25

17%

22%

27%

30

22%

26%

32%

35

26%

30%

36%

40

29%

34%

40%

45

32%

37%

43%

50

35%

40%

46%

Price/Book Ratio valuation

The role of price to book ratio is typically for relative valuation between companies but not in absolutes. Also book value is rarely marked up for asset appreciation so P/B for an older company will always be higher than a newer one. For special cases such as banks book value is fairly accurate and thus this becomes relevant for banks and financial companies.

Overall this is a valuation metric that I don,t know how to use.

Other considerations

Maximum growth of a company without altering capital structure is ROIC % x Retained earnings % - Assuming growth rates north of this is not practical

There is lots of literature out there that says that traditional measures of valuation cannot value super quality high moat companies. I don't understand that mindset. It is similar to the Phil Fisher mindset of growth investing and has produced wonderful results for several people but all stocks eventually get to levels that can be explained using simple methods of bond valuation.

Wild valuations can happen when tulip mania type activities occur. I think the power grid price soon after the IPO reached 160/share when the EPS was something like 3.25/share. Even at a discount rate of 6% a physical utility like power grid is unlikely to grow 30% a year for 5 years so that valuation was definitely too high.

Price is the biggest driver of risk

Nothing is more important than the price you buy at. To illustrate this:

Entry
Price

Exit Price

5 Year Return

80

200

20%

90

200

17%

100

200

15%

110

200

13%

120

200

11%

130

200

9%

140

200

7%

150

200

6%

160

200

5%

If the price doubles the return falls by 4x!

Overall pricing equity securities is a very vague & ambiguous science when it comes to deciding what growth and what expected return is required. Overall the goal is to buy things at a rational price where the valuations are not exuberant.